What to consider before agreeing a switch to CPI

Any decision to switch a scheme’s index from this to the more popular (outside of pensions) consumer price index is rarely made quickly and is often hotly debated.

The UK’s combined deficit could be reduced by £175bn if all schemes were to make the transition

Legal scrutiny

Quite rightfully, this decision should always be made only after thoughtful consideration. The scheme rules, membership and security of benefits must all be taken into account, as it is far from being a case of one-size-fits-all.

The ability to move a scheme away from the RPI measure in favour of the (often) less generous CPI has been possible since 2011, when the government changed statutory minimum increases from RPI to CPI.

If the move is being considered, it is essential that the scheme’s rules are first subjected to severe legal scrutiny. Rules often link pension increases to ‘the index’ and it is this definition of index that is critical. While this is often taken to mean RPI it can, sometimes, be interpreted more flexibly.

However, legal advice on the specifics of this is vital as subtle differences in wording can change the meaning significantly.

Recent court cases including British Airways, BT and Barnardo’s have shown that it can be costly and high profile to attempt to make a change, with no guarantee of success.

If both the trustee board and the sponsor reach the position that the legal requirements for switching are met, then the change for both the scheme and members can be substantial.

Breathing space

A 2017 accounting assumptions survey carried out by Hymans Robertson found that sponsors, on average, expect CPI to be 1 per cent a year lower than RPI.

The compounding effect of this over a pension fund’s lifetime means switching pension increases to this measure typically reduces a scheme’s liabilities by 15 per cent, with the potential to reduce its deficit by far more.

For example, a scheme that is 85 per cent funded could clear its deficit entirely. In fact, the UK’s combined deficit could be reduced by £175bn if all schemes were to make the transition.

As tempting as this may sound to the sponsor, it is vital to remember that this will lead to a meaningful reduction in the value of member’s benefits – around £20,000 for an average DB scheme member.  

However, for pension schemes in distress or where the scheme is very substantial relative to the resources of the sponsor, then moving to CPI can provide invaluable breathing space, relieving pressure on the scheme and helping to strengthen its ability to pay future member benefits.

Safeguarding benefits

A switch to CPI can be considered as part of a suite of measures to control a scheme’s deficit and safeguard member benefits.

For example, changing to CPI might be done as part of a triennial valuation process in conjunction with improving funding, taking less investment risk or providing non-cash support such as contingent assets.

While some trustees may initially be wary of agreeing a change, it is worth noting that reducing benefits and acting in the best financial interests of their members are not always mutually exclusive.

In fact, the position is similar to trustees agreeing to close a pension scheme to future accrual, where both decisions can be in the best financial interests of members if they lead to an improvement in the security of their benefits.

Alistair Russell-Smith is a partner and head of corporate DB at consultancy Hymans Robertson